The Black Box That is Risk Quantification

The Impact of Loss Quantification in Our Business

September 11, 2013

Charlie Woodman, CPARisk Finance Advisory

Willis National Construction

2013 Willis Construction Risk

Management Conference

Sound Familiar?From your underwriter………

“Due to market conditions and your recent claims experience, we are increasing your rates by 7%”

From your actuary…….

“Total unpaid losses increased by approximately $900,000 due to adverse loss development and an increase in claim frequency”

From your broker…….

“The carrier has increased your collateral requirement by $2 million and the LOC needs to be in place in 30 days”

From the IRS…….

“This is to inform you of the initiation of an issue regarding the valuation of unpaid loss reserves deductions under IRC Sec 482…the following must be provided regarding ABC Captive Insurance Company…”

From your DCAA auditor…..

“Your charge for self insurance is disallowed as it is not based on Projected Average Loss as defined under CAS 416”

Discussion

Loss Quantification: Basics, esp. Loss Development Methodology

Quantification Ramifications Insurance Risk Transfer Costs Collateral Costs Financial Reporting & GAAP Tax Reporting Governmental Contract

Accountability / FAR / CAS

4 years of college, 3 years grad school, four exams…for this?!

Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost

Fixed (25%-35%) Insurance Company

Overhead, Taxes,Reinsurance Cost, Commission

Profits & Losses55 -75%• Components of Traditional

Insurance:• Expected loss and

ALAE• Taxes and regulatory

fees• Overhead and

administration• Insurer selling and

distribution expense• Reinsurance and

Intermediary charges• Risk Margins

Insurance Program Risk Costs with Large Deductibles / Retentions

Fixed• Risk Transfer• Taxes• Safety & Claims Mgmt• Loss Control• Admin & Compliance

“Fixed Costs”

Incurred Losses: The Variable Stuff65% – 90+%

Losses: the 800 Pound Gorilla Sitting In The Corner

Make up the vast majority of insurance cost uncertainties

In Guaranteed Cost: Standard Premium including Experience Mods

In ‘Loss-sensitive Programs’ : Deductibles and Retentions

Losses = Pure Loss (claimant satisfaction costs) + Loss Adjustment Expense (loss reconciliation activity costs)

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Losses and their uncertainty broken down into two (2) types:

• Frequency / Burning Losses (Predictable)

• Severity / Adverse / Catastrophic Losses: Tougher to Predict - PL / Comp Op / SDI (Risk Margin)

Life Cycle of a Claim Reserve

8/1/06Accident entered into records as $1,000 Formula Reserve

7/11/06 Accident reportedClaims in Transit

10/5/06Individual reserveestablished $10,000 Case Reserve

1/1/07Estimate revised$25,000 Case Reserve

8/18/07Settlement agreed $30,000 Case Reserve

8/25/07Payment sent$30,000 Case Reserve

9/2/07Claim draft clears

Closed

4/2/06Accident occursPure IBNR

Intro To Losses A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-

But-Not-Reported (IBNR) Certain exposures will have many losses in a given policy year

which may take many years to ultimately reconcile and close. What is a Loss Reserve?

Amount necessary to settle unpaid claims Case Reserves

· Claim reported but not yet paid· Assigned a value by a claims adjuster or by formula

IBNR reserves include: Most difficult to measure and justify· Reserves for claims not yet reported (pure IBNR)· Claims in transit· Development on known claims· Reserves for reopened claims

DefinitionsPure Losses Paid to Date Case Reserves

· Claim reported but not yet paid· Assigned a value by a claims adjuster or by formula

Bulk + IBNR reserves include:· Reserves for claims not yet reported (pure IBNR)· Claims in transit· Development on known claims· Reserves for reopened claims

Loss Adjustment Expenses (LAE) are sum of:· Defense & Cost Containment (DCC) Expense (including

adjusting)

The Sum of These is referred to as “expected to ultimate” losses or “projected ultimate losses”

Projected Ultimate Loss

An estimate of total claims cost· Within the deductible layer· For a single policy period· Once all claims are settled, paid and closed.

For first party coverage (Property or Builders Risk), losses are directly measured based on property valuation whether actual cash value or replacement cost. (Short tail)

For casualty lines (AL, GL and WC), due to the lengthy period of time between the occurrence of a claim and final settlement, estimation of ultimate loss is required.

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Considerations:Emergence/Settlement

Emergence (E) vs. settlement (S)

A E S

A E S

General or Professional Liability

Workers Compensation

Automobile Liability

A

A E S

E S

Property

Basic Loss Measurement Techniques:Definitions

Sometimes solely Industry-based

Composite to Insurer Expectations

Loss Development Method using Historical Patterns

Triangles‒ Compiled to measure the changes in cumulative claim activity

over time in order to estimate patterns of future activity.‒ Loss Development Factor‒ The ratio of losses at successive evaluations for a defined

group of claims (e.g. accident year).

Components of Loss

Paid

Paid

PaidOutstanding Case

Reserves

Incurred but not reported (IBNR) Outstanding Case

Reserves

Incurred but not reported (IBNR)

3 months 6 months Claim Closed

Loss Development

Basic Reserving Techniques:Compilation of Paid Loss Triangle

Actuarial ConfigurationCumulative Paid Losses ($000 Omitted)Accident Development Stage in Months

Year 12 24 36 48 60 72

1995 3,780 6,671 8,156 9,205 9,990 10,508 1996 4,212 7,541 9,351 10,639 11,536 1997 4,901 8,864 10,987 12,458 1998 5,708 10,268 12,699 1999 6,093 11,172 2000 6,962

1. The losses are sorted by the year in which the accident occurred.

2. The losses are summed at the end of each year.

3. Losses paid to date are shown on the most recent diagonal.

4. The data is organized in this way to highlight historical patterns.

Basic Reserving Techniques:Compilation of Paid Loss Triangle

Cumulative Paid Losses ($000 Omitted) Final Accident Development Stage in Months Total

Year 12 24 36 48 60 72 Cost

1995 3,780 6,671 8,156 9,205 9,990 10,508 ???1996 4,212 7,541 9,351 10,639 11,536 ???1997 4,901 8,864 10,987 12,458 ???1998 5,708 10,268 12,699 ???1999 6,093 11,172 ???2000 6,962 ???

Basic Reserving Techniques: Paid Loss Development Factors

From the end of the accident year (at 12 months) to the end of the following year (at 24 months), paid losses for 1996 grew 79%. During the next year (from 24 to 36 months), paid losses experienced an additional 24% growth (or development) and so forth.

Loss Development Factors (LDFs) are also known as:

Age-to-Age factors

Link Ratios

Evaluation Interval in MonthsAccident 72 to

Year 12-24 24-36 36-48 48-60 60-72 Ultimate1995 1.765 1.223 1.129 1.085 1.052 ???1996 1.790 1.240 1.138 1.084 1997 1.809 1.240 1.134 1998 1.799 1.237 1999 1.834 2000

Sample Calculation for Accident Year 1996:

12-to-24 Months 1.790 = 7,541 / 4,212

Basic Reserving Techniques:Paid Loss Development Factors

Evaluation Interval in MonthsAccident 72 to

Year 12-24 24-36 36-48 48-60 60-72 Ultimate1995 1.765 1.223 1.129 1.085 1.052 ???1996 1.790 1.240 1.138 1.084 1997 1.809 1.240 1.134 1998 1.799 1.237 1999 1.834 2000

Simple Average - All Years1.799 1.235 1.134 1.085 1.052

Simple Average - Latest 3 Years1.814 1.239 1.134 XXX XXX

Simple Average - Excluding High & Low1.799 1.239 1.134 XXX XXX

Weighted Average - All Years1.803 1.235 1.134 1.085 1.052

Selected Loss Development Factors1.800 1.235 1.134 1.085 1.052 1.070

Basic Reserving Techniques:Paid LDM Projections & Reserves

Actual Cumulative Estimated Actual EstimatedPaid Development Ultimate Paid Loss

Accident Losses Selected Factors to Losses Losses ReservesYear @ 12/31/00 LDFs Ultimate [(2) x (4)] @ 12/31/00 {(5) - (6)}(1) (2) (3) (4) (5) (6) (7)

1995 10,508 1.070 1.070 11,244 10,508 736 1996 11,536 1.052 1.126 12,985 11,536 1,449 1997 12,458 1.085 1.221 15,215 12,458 2,757 1998 12,699 1.134 1.385 17,588 12,699 4,889 1999 11,172 1.235 1.710 19,109 11,172 7,937 2000 6,962 1.800 3.079 21,435 6,962 14,473

Total 65,335 97,576 65,335 32,241

First: Financial Reporting of Losses for Contractors

Financial Reporting is expense recognition Costing is a rationalization activity which is a proactive activity Financial reporting is the responsibility of Owners, CFOs,

Management, Controllers and Independent CPAs - all share the risk

Reliance by various users on financial statements:· Sureties· Banks and finance companies· Regulatory boards - licensing· Owner and prime contractor prequalification· Suppliers· Stockholders (owners)· Joint venture partners

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Recognition of Losses: Rule

A loss or group of losses is recorded only when (old FAS 5):· The likelihood of actual loss is probable, AND· The amount of the loss is reasonably subject to estimation.

If reasonable estimates of loss or losses produces a range of equally likely outcomes – (FIN 14) book the minimum.

Importance• A company cannot set aside reserves for a loss it believes might occur

before it actually happens.• If a loss occurs, a company must recognize the full value of the loss as an

expense on its financials in the accounting period in which it knows of the event

• Actual payment reduces a reserve; should not effect earnings.

ProbabilityRemote – the chance of the future

event or events occurring is slight Reporting Action: Do nothing or ID as a

Risk of Business, if large, in MD&A

Reasonably Possible – the chance of the event or events occurring is more that remote but less than likely

Reporting Action: Disclose in Notes

Probable – the future event or events are likely to occur

Reporting Action: · If Measurable: Book to Financials:

Disclose in Notes· If Immeasurable: Disclose in Notes

under “Claims, Lawsuits and Other Contingencies”

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Reasonable Reserves

Range of Estimates

Reasonable Sets of Assumptions

Evaluate Uncertainty, Risk of Material Adverse Deviation

Identify Sources of Uncertainty

Book Management’s Best Estimate

Measurability

Collateral: It All Starts HereDear Insured

“We will pay benefits and damages that are covered under this policy. We will only seek reimbursement for those amounts that are within the applicable deductible shown above. You will reimburse us promptly for any deductible amounts and all Allocated Loss Adjustment Expenses that we have addressed.”

Sincerely yours,

The Insurer

Standard Indemnity Clause: Large Deductible Program

How Does Collateral Become A Problem?

The “Deductibles” Problem

Deductible / Retention

Collateral required for unpaid claims

Commercial Insurance Specific Excess

Risk Transfer

$1 M

CommercialAggregateProtection

Per Year / Aggregate

Per Occurrenc

e

Total claim payments by policy year (Ultimate Loss)

Less claims paidPlus loss forecast for upcoming

renewal= collateral requirement

“Stacking” – Over time, collateral obligations grow (usually stabilizes after 4-7 years)

Assume 5 policy years$10M Loss Pick

$1 M paid per year

Policy Year

Rep

ort

Yea

r

AnnualCollateral

Requirement

Let’s Start On The Insurer Side

The Business of Risk UnderwritingExpected Losses and Allocated Expenses

Risk Margin: Volatility of Loss Frequency & Loss Severity

Unallocated Costs

Loss Adjustment

U/W & Acquisition Costs

Premium Taxes

Fees, Licenses & Bureaus

Other Operating Costs

Portfolio Concentration Adjustments

Investment return off-sets

Required Return on Equity (Surplus) or Opportunity Cost of re-directed capital

Counter-party Risk

Insurance Company Dynamics

Surplus is Life

Leverage Writings: i.e. 3:1 Written to Surplus

Defines Single Risk Capacity: i.e. 10% of Surplus exposure

Solidifies Reinsurance Treaties / Relationships

Statutory Accounting Principles

Annual Statement - Yellow Peril / Convention Blank / Yellow Book, etc Liquidation Value Drives Statutory Surplus

· Admitted Assets vs Non-Admitted Assets on Surplus· Schedule F· Risk Based Capital

Insurer Collateral Emphasis and Counter-Party Risk Attitude

Paid-Loss Sensitive ProgramsLarge Deductible

Paid-Loss Retros

“Fronted”

SecureLosses

Premiums, in some cases

Protection againstStatutory Penalties

Direct Obligation Default by Insureds

Sure, I’m smiling now…

So What Happen with An Insured Insolvency?

• Primary Issue -- Does Insurer Become Responsible for all Claims Payments? - Probably

• Insured / Employer Must Keep Coverage in Place.

• Insurer May Not Be Permitted to Cancel Policy.

• In Liquidation, Insurer Will Most Likely Have to Pay All Claims and File Claim for Deductible Amounts.

Crap. Now what?

The Insured Side

Issues:

Type of Security

Draw on Credit Lines

Other Debt Constraints

Liquidity Issues

Tax Planning

Amount & Timing of Collateral

Control of the Collateral

Change of Insurer Relationships

Holy $

%#%!

What Can Be Done?

Don’t Hide from the Issue

Navigating Collateral & Finding Common Ground

• Review insured’s payment agreement with their insurance company.• Defines the rights and obligations of both parties, timing of adjustments (generally at

renewal)

• Quantitative analytics / Actuarial calculation of ultimate loss• Summary loss information by line and by policy year

• Large loss listing

• Historical Exposure Information

• Understand insurance program design (i.e. ALAE treatment)

• Challenge Insurer assumptions (loss development factors, renewal forecasts)

• Request “paid loss credit” based on the insured’s historical payout patterns and financial condition

• Investigate alternative forms (LOC, Cash/asset backed, Insurance Trusts, etc)

• Claim reviews / claim closure projects – effect of collateral is intensified when losses are developed

Insurance Taxation: Basic

Non-Insurance Companies deduct loss reserves

• Deduct fixed costs, risk transfer premiums, and only losses paid in the policy year

• Future losses deducted as paid in year paid

Insurance companies can deduct loss reserves

• Advantage: take current year deductions for all losses paid, loss reserves & IBNR (reduced by IRS-imposed discount

So what about the Reserves?

$$$$

I’m not an insurance company, so what?What if I own a captive? And…

The captive must qualify as insurance company for tax purposes

• Insurance Risk• Nuance & Common Notions (Insurance

Form)• Risk Shifting & Risk Distribution

Tax deductibility hinges on whether or not the captive is a bona fide insurance company

• Although there is no “bright line” test, case law suggests that at least 30% of the captives risk must be “unrelated” to the employer in order for the employer to take a deduction for premiums paid to the captive

• Alternatively, a captive that meets IRS requirements as a brother/sister captive (i.e., Humana structure) does not require unrelated risk

Third Party Writings Approach

Captive

Parent

Sub Sub Sub Sub Sub Sub

Deductible

Outside Business

Unrelated Risk / 3rd Party

Brother-Sister Approach

Captive

Parent

Sub

Not Deductible

Deductible

Sub SubSubSubSub Sub

Balance Sheet Fact Pattern / “Humana”

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Federal Contracts and Loss Reimbursement

Key regulation* for accounting for insurance costs:

Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs

Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs

FAR 31.205-19, Insurance and Indemnification

FAR 31.201-5, Credits

FAR 28.3, Insurance

When to evaluate your current accounting practices for insurance costs?

Contracts will be CAS covered

Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification

*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html

Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html

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FAR Part 31, Cost Principles Allowability

Factors for determining allowability :“A cost is allowable only when the cost complies with all of the following requirements”Reasonableness & AllocabilityCost accounting standards, or otherwise generally accepted accounting

principles and practices appropriate to the circumstancesTerms of the contract

FAR subpart 31.2 limitationsCosts of insurance required by contract are allowableCosts of general insurance are allowable if reasonable and measured,

assigned and allocated in accordance with the requirements of CAS 416Costs of business interruption insurance must exclude coverage for lost

profitsSelf-insurance program approval is required when:

50% or > of the self-insurance costs allocable to negotiated government contracts Self-insurance costs for the fiscal year are anticipated >$200k

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Insurance Reserves

IBNR (Incurred But Not Reported)

• While generally understood by Government reviewers to be a common feature, may be concern that reserves are too large

• If Government reviewer considers reserve unreasonably large, may question a portion of the reserve and the related insurance cost

• To lessen risk of issues with purchased insurance reserves, contractors and insurance carriers should be prepared to demonstrate that reserves are reasonable based on:

· Exposure to loss· Actual loss experience· Loss Trending and / or Inflation· Loss development experience or “lag” studies

Discounting reserves not expressly required by CAS 416, but DCAA guidance suggests reserves may be subject to present value discounting (prompt payment rate)

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Measurement of Self-insurance Charges and Reserves

With significant self-insurance, typical practices for recovering insurance costs are establishing methods for:1.Estimating annual projected average losses2.Allocating self-insurance charges to segments and cost objectives

(jobs)

Under CAS 416, three ways to measure projected average loss (PAL)1.Actual Losses: actual amount of losses (where actual losses not

expected to differ significantly from PAL)2.Comparable Purchased Insurance: Estimate of the PAL based on the

cost of insurance that could be purchased for the self-insured risk3.Actuarial Measurement: self-insurance charge based on the

contractor’s or industry experience and anticipated conditions in accordance with generally accepted actuarial principles

The total of self-insured charges plus insurance charges must not exceed guaranteed cost insurance for the same exposures

Warranty (and CYA Statement)

These discussions were meant to be general in nature. We at Willis, as

risk management professionals, do have a layman’s working knowledge

of the tax and accounting issues associated with many risk financing arrangements. However, we do not

provide legal, tax or financial reporting advice. Therefore, none of

our comments in this area may be relied upon to be either accurate or

indicative of probable outcomes when applied to specific facts and

circumstances. Hear no evil, see no evil, do no evil.

I Am Not Here.

Questions

And Thank-You for your Attention

Charlie Woodman, CPARisk Finance Advisory

Willis National Construction

2013 Willis Construction Risk

Management Conference